Elasticity of demand

Introduction to Elasticity of Demand

  • Previous understanding of demand law:

    • Law of demand shows an inverse relationship between quantity demanded and price of a commodity.

    • Law of demand does not detail the extent of change in demand due to price variations.

    • Failings of the law led to the study of elasticity of demand.

Concept of Elasticity of Demand

  • Definition: The term elasticity indicates the responsiveness of one variable to changes in another.

  • Elasticity of Demand: Degree of responsiveness of quantity demanded to changes in price or other factors.

    • According to Prof. Marshall: “Elasticity of demand is great or small according to the amount demanded which rises much or little for a given fall in price and quantity demanded falls much or little for a given rise in price.”

    • Ratio Interpretation: It is the ratio of percentage change in quantity demanded to the percentage change in price.

Types of Elasticity of Demand

  1. Income Elasticity

    • Definition: Measures responsiveness of demand due to changes in consumer income, with price remaining unchanged.

    • Formula: Ey = rac{ ext{Percentage change in Quantity Demanded}}{ ext{Percentage change in Income}} Symbolically, Ey = rac{ rac{ ext{Change in Quantity Demanded}}{Q}}{ rac{ ext{Change in Income}}{Y}}

      • Where:

      • $
        ho$: Change

      • $Q$: Original demand

      • $Y$: Original income

      • $
        ho Q$: Change in quantity demanded

      • $
        ho Y$: Change in income of a consumer

    • Characteristics:

      • Positive Income Elasticity: Normal goods—demand increases with income.

      • Negative Income Elasticity: Inferior goods—demand decreases with income.

      • Zero Income Elasticity: Necessary goods—demand remains constant with income increase.

  2. Cross Elasticity

    • Definition: Measures change in quantity demanded of one commodity due to changes in price of another commodity.

    • Formula: Ec = rac{ ext{Percentage change in Quantity demanded of A}}{ ext{Percentage change in Price of B}} Symbolically: Ec = rac{ rac{ ho QA}{QA}}{ rac{ ho PB}{PB}}

      • Where:

      • $Q_A$: Original quantity demanded of commodity A

      • $
        ho Q_A$: Change in quantity demanded of A

      • $P_B$: Original price of commodity B

      • $
        ho P_B$: Change in price of commodity B

    • Characteristics:

      • Positive Cross Elasticity: Substitute goods (e.g., tea and coffee).

      • Negative Cross Elasticity: Complementary goods (e.g., tea and sugar).

      • Zero Cross Elasticity: Non-related goods (e.g., tea and books).

  3. Price Elasticity

    • Definition: The ratio of proportionate change in quantity demanded to changes in price.

    • Formula: Ed = rac{ ext{Percentage change in Quantity Demanded}}{ ext{Percentage change in Price}} Symbolically: Ed = rac{ rac{ ho Q}{Q}}{ rac{ ho P}{P}}

      • Where:

      • $Q$: Original quantity demanded

      • $
        ho Q$: Change in quantity demanded

      • $P$: Original price

      • $
        ho P$: Change in price

Types of Price Elasticity of Demand

  1. Perfectly Elastic Demand (Ed = ∞)

    • When a tiny change in price brings about an infinite change in quantity demanded.

    • Example: A 10% fall in price leads to an infinite rise in demand.

    • Representation: Demand curve is a horizontal line (figure illustrates).

  2. Perfectly Inelastic Demand (Ed = 0)

    • Price changes have no effect on quantity demanded.

    • Example: 20% price drop does not affect quantity demanded (e.g., salt).

    • Representation: Demand curve is a vertical line (figure illustrates).

  3. Unitary Elastic Demand (Ed = 1)

    • Percentage changes in price and quantity demanded are equal.

    • Example: A 50% fall in price leads to a 50% rise in demand.

    • Slope of curve is a rectangular hyperbola (figure illustrates).

  4. Relatively Elastic Demand (Ed > 1)

    • A percentage price change results in a greater than proportionate change in quantity demanded.

    • Example: 50% price drop leads to a 100% rise in demand, hence Ed = 2.

    • Demand curve appears flatter (figure illustrates).

  5. Relatively Inelastic Demand (Ed < 1)

    • A percentage price change leads to less than proportionate change in quantity demanded.

    • Example: 50% price drop leads to a 25% rise in quantity demanded, hence Ed = 0.5.

    • Demand curve appears steeper (figure illustrates).

Measuring Price Elasticity of Demand

  1. Ratio Method (Percentage Method)

    • Developed by Prof. Marshall.

    • Elasticity measured by dividing percentage change in demand by percentage change in price.

    • Formula:
      E_d = rac{ ext{Percentage change in Quantity demanded}}{ ext{Percentage change in Price}}

    • Example: For price changes from 20 to 25 and quantity demanded changes from 10 to 9, calculations lead to a relatively inelastic demand (Ed < 1).

  2. Total Expenditure Method

    • Compares total expenditure before and after price changes.

    • Total expenditure = Price × Quantity demanded.

    • Level of elasticity determined by total outlay changes:

      • Ed > 1: Total outlay increases with a price drop (Relatively elastic).

      • Ed = 1: Total outlay remains the same (Unitary elastic).

      • Ed < 1: Total outlay decreases with a price drop (Relatively inelastic).

    • Example in tabular form illustrates this method with different price-quantity scenarios.

  3. Point Method (Geometric Method)

    • Measures elasticity at a specific point on the demand curve.

    • Formula:
      [ E_d = \frac{\text{Lower segment below a point} (L)}{\text{Upper segment above a point} (U)} ]

    • In linear demand curves elasticity varies, while in non-linear curves, a tangent line is used to derive measures.

Factors Influencing the Elasticity of Demand

  1. Nature of Commodity:

    • Necessaries: Demand is relatively inelastic (e.g., food).

    • Comforts and Luxuries: Demand is relatively elastic (e.g., cars).

  2. Availability of Substitutes:

    • Close substitutes lead to more elastic demand (e.g., lemon juice vs. sugarcane juice).

    • No close substitutes lead to inelastic demand (e.g., salt).

  3. Number of Uses:

    • Single-use goods have less elastic demand. Multi-use goods are more elastic (e.g., coal, electricity).

  4. Habits:

    • Addictive goods lead to inelastic demand (e.g., drugs).

  5. Durability:

    • Durable goods tend to exhibit elastic demand (e.g., washing machines).

    • Perishable goods are usually inelastic (e.g., milk).

  6. Complementary Goods:

    • Goods that complement each other will have inelastic demand (e.g., mobile handsets and SIM cards).

  7. Income of the Consumer:

    • Higher income leads to generally inelastic demand. Demand is less affected for wealthier individuals.

  8. Urgency of Needs:

    • Urgent goods will have more inelastic demand (e.g., medicines).

  9. Time Period:

    • Longer time periods generally allow for greater elasticity as consumers adapt their habits.

  10. Proportion of Expenditure:

    • Items that take a small proportion of income tend to have inelastic demand (e.g., newspapers). In contrast, items that use a large proportion are elastic.

Importance of Elasticity of Demand

  • Integral for producers, farmers, workers, and government policy.

    • To Producers: Helps decide pricing strategies to maximize revenue based on elasticity understanding.

    • To Government: Influences taxation policy, taxing inelastic demand more heavily.

    • Factor Pricing: Higher demand leads to higher wages in relatively inelastic markets.

    • Foreign Trade Impact: Elasticity aids in setting terms for exports, important for exporting countries.

    • Public Utilities Management: Knowledge of inelastic demand can lead to appropriate policy (subsidies/nationalization).

Applications and Exercises

  • Analyze goods to determine types of elasticity (e.g., cosmetics, medicine).

  • Understand how to apply elasticity concepts in various scenarios by answering related questions and exercises to test comprehension and application of knowledge learned.

This document outlines the various dimensions of elasticity of demand, referencing definitions, formulas, and critical importance in economic analysis.